The US Federal Reserve's decision to start cutting back on the amount of money it pumps into the economy each month seems to have buoyed already strong equity markets, with the Standard & Poor's 500 index reaching a record on Wednesday, but things could just as easily turn around in the next few days if the bond market starts to get spooked, according to Chief Investment Officer Haig Bathgate.
What's probably driving this initial euphoria is relief that the process will start without the world actually collapsing. We've long highlighted the risk to both equity and bond markets from tapering. For equities, the main concern was the prospect that the cheap cash that had supported stock markets since the financial crisis was coming to an end. The Fed's indication that it may hold interest rates at record lows, even if unemployment falls to 6.5%, has reassured equity investors that the era of easy money isn't quite finished yet.
But equity markets also face downward pressure if bond prices start to sink. The US government has implemented quantitative easing (the injection of money into the economy) by paying cash to buy $85 billion of bonds and other securities every month. The end of this process means lower demand for bonds, which should cut prices and send yields higher. While this may hurt holders of bonds, stock markets aren't immune from this trend, as the prices investors pay for equities are based in some part on bond yields – the higher the yield, the higher the hurdle for an equity to be worth buying. So far, bond markets have stayed steady (the US 10-year yield climbed just four basis points yesterday – it increased from 1.6% to 2.9% over the summer after the Fed first started hinting it would slow QE).
But there's also a significant upside to the Fed's announcement that's yet to show. Companies in recent years have been sitting on piles of cash but have been unwilling to spend that money on their businesses. We've heard anecdotes that executives have been waiting for a signal from central banks that the economy is strong enough to warrant an increase in capital expenditure, and this statement may be just that sign. If companies were to increase that spending, that would help lift markets further again.
The Fed's decision does indeed signal a confidence that's been lacking since the financial crisis started more than five years ago. We think stock investors have reacted over-optimistically to the tantalising suggestion that rates may remain low for longer. The Fed has shown that it can change its mind when the data points a certain way – it unexpectedly balked at tapering earlier this year, while only a minority of economists predicted they'd start tapering at this meeting. With the data in the US showing a stronger recovery, the Fed may yet speed up the tightening process faster than people are expecting.
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